Time Not On Our Side: Tough Decisions Needed To Strengthen Financial Stability

Recent policy actions in Europe, the United States, in emerging markets, and here in Japan, where I'm attending the IMF-World Bank annual meetings, have improved investor sentiment and helped markets rebound in recent months.

Yet our latest assessment is that confidence is still very fragile and risks have increased, when compared to the IMF's last report in April. Policymakers need to do more to gain lasting stability.

The principal risk remains the euro area. The forces of financial and economic fragmentation have widened the divide between countries at the core and the "periphery" of the euro zone. Faltering confidence and policy uncertainty have led to a pullback of cross-border private capital flows from the periphery - quite an extraordinary phenomenon within a currency union.

This has driven up funding costs to governments, banks, as well as for corporates and households, and, in turn, threatens a vicious downward economic spiral.

Can this process of fragmentation be reversed? My firm belief is yes.

As recognized in our Global Financial Stability Report, actions taken by the European Central Bank have helped remove investors' worst fears. Now policymakers at both the national and euro area level will need to build on these.

The stakes are high. For instance, if pressures continue, total assets of major banks in Europe could shrink by as much as $2.8 trillion, possibly leading to a contraction in credit supply in the periphery by 9 percent by the end of 2013. In a more adverse case, as illustrated in our weak policies scenario, European Union bank assets could shrink by as much as $4.5 trillion, and lead to a reduction in the supply of credit in the periphery by up to 18 percent. In contrast, a rapid move to complete policies would avoid this economic damage.

So what is needed?

Safer banks: policymakers have made progress, including the European Banking Authority's capital enhancement exercise, but weak banks still need to be restructured or resolved.

Strong firewalls: The European Stabilization Mechanism and the European Central Bank's bond purchasing program should have credible conditions so they are regarded by financial markets as real, not "virtual."

A stronger union: establishment of the Single Supervisory Mechanism is an important step that policymakers need to implement without delay. A clear roadmap to a complete banking union is required to guide market expectations and help break the pernicious link between sovereign and bank balance sheets.

A key lesson for the United States and Japan from the euro area crisis is that delaying policy adjustments until market strains become evident leads to financial turmoil and harsher economic outcomes. Fiscal imbalances in the United States and Japan are amenable to medium-term adjustment, but a blueprint for policy actions must be developed right away.

We cannot let current market conditions give rise to a false sense of security. Safe haven flows to the United States and Japan and easy monetary policies have led to record low interest rates, and have suppressed risk premia in government and corporate bond markets.

Furthermore, a potential political impasse in the United States could result in a repeat of the debt ceiling strains that occurred in the summer of 2011 and a possible push over the fiscal cliff. Policymakers and politicians should avoid both risks and put an end to these policy uncertainties.

Japan's high sovereign debt and rising concentration of government bond holdings in the banking system are important stability risks. We project bank holdings of government bonds could rise to about one-third of banks total assets in five years time. This would tie banks ever closer to the sovereign and potentially weakening financial stability should interest rates rise.

To mitigate these effects, macroprudential vigilance and a further strengthening of bank balance sheets and bank business models, together with much-needed fiscal consolidation.

Are emerging markets safe? As a whole, emerging markets have navigated global risks skillfully, but they must keep up their guard. Several central and eastern European countries are most vulnerable because they are directly exposed to European bank deleveraging pressures, while some private balance sheets are weak.

Asian and Latin American emerging markets are less impacted by shocks emanating from Europe, but are not immune to adverse external spillovers. Following a period of rapid credit growth some key economies in both regions have reached the late stages of the credit cycle. These tend to be accompanied by peaking asset prices, and early indications of worsening loan quality. In the face of the global slowdown, emerging markets need to use their available policy space wisely, and address domestic vulnerabilities.

Banks, policymakers and regulators have accomplished a lot, but confidence is still fragile. This is the time when governments need to complete what they have started to enhance actions already taken by central banks.

The choice today is between making the necessary but tough policy and political decisions, or delaying them - once more - in the false hope that time is on our side. It is not.

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